In just 90 minutes, Hong Kong-listed China Huishan Dairy saw its shares plunge by 85 percent in March last year, wiping US$4 billion off its market capitalization.
The sell-off occurred weeks after activist short seller Muddy Waters Research published a report accusing the company of inflating its profit margins, revenue and capital expenditure, and concluded the company was “worth close to zero.”
China’s largest integrated dairy company eventually filed for provision liquidation in November last year with estimated debts of RMB10.5 billion.
China Huishan Dairy is not the only Hong Kong-listed company to catch the attention of short sellers. Luggage company Samsonite, e-commerce platform Cogobuy Group and aluminium smelter China Hongqiao Group, to name a few, all suffered steep share price falls following the publication of critical reports by research groups.
Short selling is on the rise in Hong Kong, and despite the negative impact it can have on individual companies, many investors view the trend as an important feature of a healthy market.
Short selling refers to the practice of borrowing shares from a third party and selling them, in the hope that they can be bought back at a later date for a lower price, generating a profit. The majority of short selling is done by institutional investors and hedge funds as a way of cushioning investors from falling markets or because they believe companies have become overvalued.
There is also a vocal group of activist short sellers that publish research reports on companies they think have fraudulent business or accounting practices. These reports typically trigger sharp share price falls or lead to trading in the target’s shares being suspended.
In the first six months of 2018, average daily short selling turnover in Hong Kong totalled HK$14.5 billion, accounting for 11 percent of total market turnover, up from 9 percent of turnover in the first half of 2012, according to figures from the Securities and Futures Commission (SFC).
Despite the increase, in general, short selling in Hong Kong remains significantly lower as a proportion of total market turnover compared with more mature markets, with short selling turnover on the New York Stock Exchange and the Tokyo Stock Exchange typically accounting for more than 20 percent of daily trades.
Jeffrey Chan, Director of asset manager OP Investment Management, points out that short selling in Hong Kong was higher in both absolute terms and as a percentage of total market turnover during the first half of 2018, compared with a year earlier. He suggests the increase may simply reflect investors taking a more cautious view of market conditions.
But Kevin Leung, Executive Director – Investment Strategy at Haitong International Securities, says there has also been an increase in activist short selling reports targeting Hong Kong-listed companies. He thinks the rise is being driven by a combination of companies being overvalued or overhyped, as well as an increase in new economy companies that use non-traditional accounting standards that do not always simply reflect the true value of the business.
There are also suggestions that activists are deliberately targeting companies in the region due to perceived weaker corporate governance standards, which create opportunities for short sellers.
Soren Aandahl, Founder and Chief Investment Officer of short seller Blue Orca Capital, whose research report on Samsonite’s accounting practices caused its chief executive officer to step down in May, says: “Every market, no matter how mature, will have rotten apples. That said, I think corporate governance standards are more mature in markets like the United States as compared to the Asia-Pacific region.”
He adds that while many companies in Mainland China hold themselves to the highest standards of truthful disclosure, accountability and good governance, others do not. “In the Hong Kong and Chinese markets, there are some companies that are tightly controlled by an all-powerful chairman, unchecked by strong independent directors and basically unaccountable to shareholders,” he says. It is companies such as these that are particularly vulnerable to activist short sellers.
Carson Block, Founder of Muddy Waters, is more critical. He says: “Corporate governance in Hong Kong is poorer than in most, if not all, of the developed markets that we have observed. Boards of directors tend to be more incestuous and when we see stock manipulations and fraudulent promotions, we often see the same directors involved in numerous problematic companies. Even in cases where the misconduct has been proven, most of these corporate directors go unpunished. That’s a bad sign.”
A dissenting voice
Short sellers are often viewed by the companies they target as a destructive force that increases share price volatility. The potential negative affect they can have on a market is also reflected by the fact that regulators in some countries have banned the practice during periods of significant turbulence. For example, the short selling of financial stocks was banned by the United States’ Securities and Exchange Commission in 2008 during the global financial crisis. Despite this fact, many investors consider short selling to be an important feature of a modern and developed financial market.
An SFC spokesman points out that short selling activities are used to facilitate a wide range of market activities, including managing the price risk of derivatives products, enhancing price efficiency, and increasing liquidity in the market.
Chan adds that the practice also enables investors to deploy different investment strategies, allowing them to benefit from both rising and falling markets. “Short selling enhances the price discovery process in the stock market. It helps generate more accurate pricing and reduces the risk of securities becoming overvalued,” he says.
“Dissenting opinions are so critical to the markets because they are so few. So many of the voices in the market are incentivized to pump companies and avoid any critical commentary of management.”
Block points out that activist short sellers add to transparency by providing more information for investors to make their decisions and by pressuring companies into being more transparent and investor-friendly. “Non-activist short selling is also an important price signal for long investors,” he says.
Aandahl puts it more strongly, saying: “Dissenting opinions are so critical to the markets because they are so few. So many of the voices in the market are incentivized to pump companies and avoid any critical commentary of management.” He points out that the management teams of listed companies are incentivized for stock prices to go up, regardless of whether they exceed the basic fundamental value of the underlying business, while investment banks that issue research reports also get paid for banking business generated by listed companies, such as initial public offerings, and acquisitions through debt and equity issuances.
Aandahl adds that the relationship between service providers, including auditors and law firms, and companies can act as a deterrent to them alerting the market to issues. He says: “Short sellers occupy a unique place in the eco- system. As a lone dissenting voice, they can offer a critical opposing viewpoint among of cacophony of voices relentlessly pumping a stock.”
Short sellers can also act as a deterrent to management misconduct, while markets allocate capital more efficiently when there is greater transparency, he adds.
Regulatory restrictions
Sometimes, false information is circulated. An SFC spokesman says: “The main regulatory concern is the potential for short selling to be used to facilitate market abuse or to cause extreme price movements, such as triggering a precipitous stock price decline, which may contribute to disorderly markets when market confidence is fragile.”
Hong Kong has a robust regulatory regime governing short selling, with a number of restrictions placed on the practice. Only securities that meet certain size and liquidity requirements are eligible for short selling, excluding many smaller companies, while only “covered” short selling – under which short sellers must have borrowed the securities before placing any short selling orders in the market – are permitted.
The SFC also requires a full audit trail for all covered short sales, and short sales must be executed at or above the best current ask price, known as the “tick rule,” on the Hong Kong Stock Exchange’s trading system.
Short positions held by market participants above certain thresholds must also be reported to the SFC on a weekly basis. The SFC’s spokesman says: “Hong Kong has put in place a robust regulatory framework to minimize the potential risks while realizing the benefits of short selling as much as possible.”
But Aandahl would like Hong Kong’s regime to be expanded to allow the short selling of shares in smaller companies, pointing out that under the current rules, a large part of the market is not shortable.
“This rule has a paradoxical effect of removing the counterweight of shorts to smaller companies where it is needed the most – because, as a general rule, smaller companies are less likely to have optimal governance structures and are more vulnerable to promotional management teams and questionable accounting decisions by management,” he says.
Despite the regulatory measures in place, the market is not immune from abuse, with the SFC taking four enforcement actions in the past nine months in relation to non-compliance with short selling regulations.
Short selling victim China Hongqiao Group also took the step of obtaining a court injunction last year against Hong Kong-based Emerson Analytics, preventing it from releasing any further negative reports on the company.
There is also not much to stop short sellers from circulating false information. Leung at Haitong International Securities says: “These reports can bring chaos to the market without any substantiation. If someone wanted the share price of a company to come down, they could just make something up and put it in a report.”
But he adds that while tighter regulation in this area would be desirable, there are often limits to what local regulators can do, as many of the short seller activists are based offshore.
Company defenders
Accountants have a significant role to play in both helping companies avoid becoming short selling targets and identifying companies with suspect accounting practices. “The key role of public accountants for listed companies is to ensure that financial statements give a true and fair view of the company’s financial position,” says the SFC’s spokesman. “This would go a long way towards helping the company defend itself against any allegations questioning its financial position.”
Leung thinks activist short sellers are increasingly targeting companies with accounting that is “irregular or complicated,” particularly for new economy companies that may have fair value changes or incorporation of less common accounting standards that can be more difficult to verify for the normal investor.
In these cases, he thinks accountants can act as “gatekeepers,” closely monitoring results and ensuring the company’s accounts are a fair representation of the underlying business.
Chan agrees, pointing out that the financial reports prepared by accountants are used by investors as one of the key bases for making investment decisions. “Short sellers often deploy forensic accountants to decipher complex financial positions of listed issuers to screen potential short selling targets,” he says.
Aandahl also believes accountants have a crucial role to play in finding short selling targets: “Many good short ideas begin with basic financial statement analysis, and thorough scrub of a company’s critical accounting policies.”
He gives the example of a report by Glaucus Research Group, where he worked before founding Blue Orca Capital, which accused China Metal Recycling of securities fraud on the grounds that it was deceiving the market about the size of its business. Glaucus used publicly accessible import data from the Chinese government to show that the company could not be legally sourcing anywhere close to the volume of scrap needed to produce its reported volume of processed metals. Its report proved to be right, and China Metal Recycling was eventually wound up following an SFC court order.
It is because of instances like this that Aandahl believes activist short sellers have a vital role to play in a healthy market. “There will certainly be growing pains but in the long run, increasing management accountability through truly independent and strong boards and increasing transparency through more robust disclosures will only enhance shareholder returns and the overall attractiveness of these markets.”
In the first six months of 2018, average daily short selling turnover in Hong Kong totalled HK$14.5 billion, accounting for 11 percent of total market turnover, up from 9 percent of turnover in the first half of 2012, according to the Securities and Futures Commission.
